Monday, August 22, 2011

The Other Side of Household Balance Sheets

A popular explanation for the ongoing economic slump is that the United States is in the midst of a balance sheet recession. This view holds that the vast amount of household debt built up during the housing boom is now being unwound and that this deleveraging is creating a drag on the economy. Though intuitive, this balance sheet recession view is inadequate because one, it ignores the potential offset in spending by creditors and two, it misses a more fundamental problem: the elevateddemand for liquidity. I believe one of the reasons for this confusion is that advocates of the balance sheet recession view tend to focus on the liability side of household balance sheets while ignoring the details of the asset side. A close look at the asset side reveals that despite the collapse in overall household assets, there has been a inordinately large buildup of liquid assets. It is this accumulation of money and money-like assets rather than the deleveraging itself that has kept nominal spending from experiencing a robust recovery. Here are the numbers.

From the peak of household asset values in 2007:Q2 to the latest data for 2011:Q1, households have lost around $9.4 trillion worth of non-liquid assets. Despite these large losses and the subsequent slump in personal-income growth, households have somehow increased their holdings of money and money-like assets by a staggering $1.6 trillion as seen in the figure below:

The composition of the increase in liquid assets is also interesting. Most of the increase has come in the form of time and saving deposits, though treasuries have been important too. Money assets alone (cash, checking account, time and saving deposits, money market accounts) have remained elevated and close to their peak value in late 2008. And, as John B. Taylor notes, money demand appears to be growing even more.

I personally place more importance on the growth of the money assets in slowing down nominal spending for two reasons. First, they are fixed in nominal value and thus only grow by households actively acquiring them. Treasuries, on the other hand, may be increasing through acquisition and valuation change. Second, the demand for liquid assets in general can only affect nominal spending by influencing the medium of exchange, money. It is the only asset on every other market and thus is the only asset that can directly affect nominal spending. An elevated demand for treasuries matters, then, by by spilling over to the demand for money.

As a share of total assets, household's liquid assets have risen and remained elevated as seen in the figure below.

Now some may note that the rise in the share of liquid assets is not all that large in terms of percentage points. A rise in the share of liquid assets, however, does not need to be terribly large to impede nominal spending. This is especially true with money assets because they are the medium of exchange. One would expect nominal spending to be sensitive to changes in money demand. The figure below confirms this. It shows the relationship between the growth rate of money assets as a share of total assets and the growth rate M3 velocity for the period 1951:Q4 through 2011:Q3. (The M3 data comes from NowandFutures.) The relationship is surprisingly strong, given that money velocity can also be affected by factors like innovations in financial transactions.

Observers, therefore, need to be paying more attention to the build up of money assets in household balance sheets. Until this development changes, there will be an ongoing drag on nominal spending. One way to address this problem is to introduce a nominalGDP level target. This is how it would work in practice.

Update: In the comment section I further explain why excess money demand rather than deleveraging is the reason for the weak aggregate demand.

25 comments:

Your third graph shows that up until 1980 households were holding an increasing share of wealth in money/money-like assets peaking at 17.5% of total assets. This makes the recent increase seem not 'inordinate'.

De-leveraging can be reducing the rate of taking on additional debt, as opposed to paying off existing debt more quickly. And bankruptcy is the ultimate household de-levering event. Neither scenario is creditor-friendly.

In all, these data don't seem to me to be inconsistent with the 'balance sheet recession' story: an increased desire to save to repair balance sheet damage and a shift in portfolio preference to less risky assets.

Price levels in 1929-1934 were deflating. Roosevelt could manipulate the $/gold ratio. Mr. Bernanke's tools seem less precise and current economic conditions less auspicious for successful monetary operations. And he may never be able to visit Texas again if he tries.

The liquid asset share does spike in the early 1980s, but that is because there was a severe recession. And the comparison between then and now is spurious since there was a prolonged, structural shift in the share of household assets that were liquid starting in the late 1980s through the late 1990s. In other words, the right comparison is with the period prior to crisis not several decades ago when household balances were very different.

Yes, deleveraging can be include (1) outright default, (2) reducing the rate of debt accumulation, or (3) paying off debt more quickly. In all cases, though,it is excess money demand that is causing the decline in nominal spending, not not the various forms of deleveraging that is the problem.

In (1), if the household defaults, then they keep the money that otherwise would have gone to creditor. For example, a household may decide an underwater mortgage is no longer worth the pain. If instead of making a mortgage payment they spend the money on other things, then there is no excess money demand and no drag on nominal spending. If, on the other hand, they sit on their funds because of say job uncertainty then there is an excess money demand problem and nominal spending is affected.

Likewise, with (2) if they cut back on debt accumulation the issue is again whether there is an excess demand for money--either by them or potential creditor that would have lent them--that is holding up nominal spending, not deleveraging itself.

Finally, with (3) if the creditor is a non-bank then the question is simply what does the creditor do with the newly acquired money assets: spend them or sit on them? If it is the latter, the issue is again money demand. If the creditor is a bank then the debt paydown reduces both the assets (i.e. loan) and liabilities (i.e. deposits) in the banking system. The the latter development, a reduction in deposits, means a contraction in the money which for a given money demand creates an excess money demand problem.

Focusing on deleveraging misses the true cog in the system.

Regarding FDR, see my previous post. There were notable reductions in current dollar debt between 1933 and 1935. Also see the end of the Telegraph article linked to in the previous post. Economic circumstances were far more dire in 1933 when FDR ushered in his price level target. Finally, if deleveraging is really the issue then how come it hasn't stop Sweden from a robust recovery?

Given the distribution of financial assets by wealth, much of the build-up in liquid assets likely accrued to wealthy households. These households were also creditors to the shadow banking system. I would not be surprised to learn that the build up of liquid assets more or less matches the fall in shadow banking liabilities. Since these liabilities were precisely intended to transform maturities and provide "liquidity", they were an intended substitute for safe, liquid assets.

Would the replacement of "liquid" shadow banking liabilities with truly liquid ones be a structural or cyclical phenomenon?

Good point on the possibility of funds leaving the shadow banking system. I think that is one possibility, but there may be another.

(1) As you suggested, institutional money market accounts deposits are being drawn down as funds from the shadow banking system are being moved into the safe, FDIC insured time and saving deposit category. Here, the demand for safer, M2 money assets is increasing but the net deposits are not changing.

(2) Banks might be creating more time and saving deposit accounts. The banks could be buying up treasuries from the public as their yields drop. In this case, there is a net increase in deposits. Money demand is clearly rising here.

Regarding your last question, I would argue the switch is coming from the recent economic shocks and is thus more cyclical.

I agree that your second item -- bank intermediation of Treasuries -- is a factor.

On cyclical vs. structural: One way to look at it is that AAA-rated, s.t. shadow banking liabilities were considered safe, liquid assets by their holders. Thus, part of the large flow into bank deposits and Treasuries is the result of a shift in demand from one type of "money" to another. The shift is more-or-less permanent (structural) as shadow banking liabilities will not recover their "moneyness".

In other words, perhaps if AAA-rated shadow bank liabilities had not existed, (most of) those funds would have been parked in your "safe, liquid" category all along.

One implication of the above is that part of the "money demand" issue is really an impairment of the credit channel. How do we restore the shadow banks' former function: intermediating between safe, liqiuid liabilities and risky assets? That role presumably now falls to banks, but they are reluctant to accept it. One solution would be to force banks to take un-recognized mortgage losses and raise capital, thus restoring the health of the system.

I see now your point: there has been a structural change in financial intermediation. Fair enough.

Lately, I have been trying to make sense of the implications of the shadow banking system for monetary policy. Some folks like Stephen Williams say, I think, that because the shadow banking system the Fed is just another bit player in financial intermediation and really cannot do that much. What are your thoughts on it?

Here is another from the FT: http://ftalphaville.ft.com/blog/2011/08/24/661146/an-important-lesson-from-jackson-hole-2010/ One of the QE2 critiques laid out there is that the shadow banking system took the new funds from QE2 and parked them in commodities and emerging markets. Assume all of that is true. It seems that if that if this is possible, then sellers of commodities and emerging market assets must not have satiated their desire for dollars. Any thoughts?

I agree with Williamson on the effctiveness of QE "asset swaps". The counter-argument is that they work by signaling the path of future policy. The problem is if they don't work now, why would a commitment to do more of them in the future have an effect?

A mechanism that does work is the effect of ZIRP and negative real rates on speculators. With large swaths of the shadow banking system gone, what remains (e.g. hedge funds) is more speculative in orientation. This is really the "only game in town" for policy transmission. The problem is that speculation is unreliable: it suffers from agency problems and can have abrupt shifts in risk preferences. Also, speculative flows go to unintended destinations (commodity funds, BRIC "hot money").

It seems that actors are bifurcated. One group wants to hold money at a penalty rate; the other wants to hold assets to exploit that rate. This explains why both nominal yields and credit spreads could be so low at the same time. What's missing is the traditional intermediation by banks. Why don't the Fed and Treasury force a recapitalization of the sector? Combined with easing, this would be a more "nordic" solution.

Your proposal a forced recapitalization combined with monetary easing sounds reasonable. Some kind of recapitalization/debt write off seems almost inevitable since fiscal and monetary policy are off the table.

But I still have questions about the asset swap equivalence claim. Say the Fed progressively buys up US treasuries across the term structure. As it buys longer-term treasury securities, how would this be an equivalent asset swap? Why wouldn't investors' portfolios be weighted too much with money assets and thus need to be rebalanced?

"Update: In the comment section I further explain why excess money demand rather than deleveraging is the reason for the weak aggregate demand."

this post is silly. excess money demand and deleveraging are two sides of the same coin. criticizing the balance sheet recession view on those terms is like criticizing people who think there is a shortfall in aggregate demand by saying that there is an excess of aggregate supply. they're just different perspectives, not contradictory ones.

Now, as the Fed buys further out on the curve, it is replacing a longer-term duration safe asset with a shorter one. It absorbs the duration risk formerly borne by the sellers. It then effectively transfers this risk to the Treasury (via future Fed profit remittances), which then transfers it back to the private sector (via future taxes or Treasury supply). In aggregate, the private sector's duration risk is unchanged by QE. Some actors (those selling Treasury bonds) might seek to extend their resulting duration; others (taxpaying households, bond owners fearing future Treasury supply) would seek to reduce theirs.

This may be just stating the obvious, but: debt repayment is not income for anyone. There is no reason for 'creditors' to increase their consumption in response to debt repayment. Monetary policy correctly focuses on the behavior of borrowers. And when people don't want to borrow money (to buy houses, for example), even when the risk free rate is pegged at 0%, then monetary policy can't do anything.

Nathan:Excess money demand is not exactly the flip side of deleveraging. They can be related, but not necessarily. For example, households could still be deleveraging and yet the Fed through a higher inflation target could cause money demand to fall. See my earlier post on the 1933-1936 period when there was still deleveraging by spending was increasing (i.e money demand was falling).

Anonymous 1:56:There are many channels through which monetary policy works, not just the interest rate (borrowing)channel you mention. Monetary policy works through changing expectations, asset prices, causing portfolios to be rebalanced, etc. For example, if the Fed set a permanently higher inflation target it would create an incentive for the holders of money assets to unload them and diversify into higher yield assets.

Anonymous 6:57 am:I am aware of flow of funds data problems, including the ones you mention. Unless there is double counting, though, the fact that hedge funds fall into the HH category doesn't undermine my point since alot of the hedge fund funding comes from wealthy households (i.e. the creditors).

Anonymous 7:08 am:Yes, there is a slowdown in the the growth rate of deposits relative to pre-2007 but that is a spurious comparison. The proper comparison is one relative to other assets currently, given the dramatic change in economic environment. And as I show show above, money assets have been growing despite all that is going on, a sure sign of excess money demand.

Anonymous 7:10 am:The liquid share increased in highly correlated with the drop in spending. So whether the share increase was caused by accumulating more money assets or by holding onto money assets as other assets fall is irrelevant. The point is that either way households are hanging onto money assets despite the worsening economic conditions, a sure sign of excess money demand.

And no, if the Fed were doing its job I would not expect the liquid share to increase necessarily. For example, if housing prices collapse but the Fed through the raising of its inflation target kept nominal spending stable then the overall economy should be stable, other asset prices supported, and the liquid share should not increase. This in fact happened initially. The housing market reached a peak in April 2006 and headed down thereafter. The Fed did a decent job stabilizing nominal spending (i.e. keeping money demand in check) through much of 2007. Not until late 2007 is there a noticeable spike in the share of liquid assets. The real spike, though, occurs in mid-2008 when nominal spending really tanks, indicating a sharp increase in money demand. See this figure for more: http://research.stlouisfed.org/fredgraph.png?g=1Of

Anonymous 7:28 am:Economic uncertainty has increased the liquid share. My point is that it is the rise in this share (i.e. the rise in money demand) that is the thwarting spending and that it could be managed by the Fed.

Anonymous 7:31 am:I am for something like a Fed-funded payroll tax cut that is conditional of nominal GDP returning to trend. http://macromarketmusings.blogspot.com/2010/09/right-kind-of-helicopter-drop.html

I don't think proponents of balance sheet recessions miss that there is elevated demand for liquidity - quite by contrast, deleveraging by debtors and excess holding of liquid assets are the flipside of the same coin. Debtors have a higher propensity to consume - this is why they are debtors - but are liquidity constrained, as a result of the crisis and the resulting loss of value of their collateral.

Debtors therefore have to limit absorption, and transfer income to their creditors. Creditors want to save this income, but there aren't sufficient safe and liquid assets, thus they hoard money.

This turns into a problem for monetary policy only once it is close to the zero bound — but this is where the U.S. economy is. The larger post-crisis deleveraging, and the larger the income transfer from debtors to creditots, the bigger the risk that moentary policy would get stuck at the zero bound.

Anopther critical aspect is that the U.S. economy as a whole is indebted abroad. Thus, part of the income transfer is from domestic debtors to foreign creditors, triggering a drop in the demand for U.S. goods even in the absence of money hoarding.

The Fed could counter this by trying to enigineer a weaker U.S. dollar, but in a world of partially fixed exchange rates (China) this isn't easy.

"For example, if the Fed set a permanently higher inflation target it would create an incentive for the holders of money assets to unload them and diversify into higher yield assets."

Stocks, I doubt it would have much effect, because it's not easy to arbitrage between cash and stocks. Cash and government bonds, yes. So such a commitment would certainly cause bond yields to fall to Japan levels. And then what?